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Taking advantage of hybrid securities

Hybrid securities have gained favour with yield-chasing investors, but there are traps for the unwary. How can investors capture the benefits while managing the risks?

Firstly, a definition: hybrid securities are complex products that contain features of both debt and equity that allow banks and companies to borrow money from investors.

While hybrids can offer attractive rates of return, Morningstar's senior credit analyst John Likos cautions investors against treating hybrids as fixed income investments or as a substitute for low-risk investments such as term deposits.

"Particularly with the background of falling yields, some investors have chased yield without paying attention to the risks involved with the underlying issuer," Likos says.

He says investors should consider an issuer's creditworthiness, along with the structure of the security itself--"the more favourable to the investor, the better".

"The older-style hybrids such as ANZPA and WCTPA were probably more investor-friendly in that they had fewer issuer-friendly terms and triggers, compared to securities such as those issued by Crown (CWN), which suffered a sharp fall before rebounding amid speculation over the company's restructuring," he says.

He also points to the risk of a "reversion to the mean" in default rates after a long period of "extremely low" defaults in Australia.

"We've come off a bullish cycle in the default lifespan, but now as you're seeing company growth being more challenging, we're expecting a slight trickle up in distress rates," Likos says.

Morningstar suggests investors focus on securities issued by companies with low or medium issuer risk ratings and wide or narrow economic moat ratings, with an emphasis on stable yield and maturity.

Among those recently favoured, but yet to be listed, are the NAB Capital Notes 2 (NABPD), which was offering an estimated gross running yield of around 7 per cent, and the Westpac Capital Notes 4 (WBCPG), which was offering a similar yield. Both are from wide moat-rated issuers.

Morningstar's "Australian Credit Monthly" report for May highlighted Australia's relatively high yields compared to other developed markets.

In May for example, the Australian 10-year government bond yield was trading at 2.33 per cent, compared to the negative or near-zero yields for Japan and Germany, while UK and US bond yields were also trading below 2 per cent.

However, a potential new avenue for Australia's major bank hybrid issuance has emerged in the offshore market, a move that could reduce supply pressures in the domestic market.

"ANZ went to the US market and issued a hybrid there following a private ruling from the ATO that it didn't need to pay franking credits on its overseas notes. That's opened up a whole new avenue for domestic issuers into overseas markets and we expect other major banks to at least consider this avenue in the future," Likos says.

"Interestingly, ANZ sought $1 billion but its issue was 18 times oversubscribed, indicating the strength of overseas demand for the higher-yielding Aussie hybrids [in ANZ's case, 7.5 per cent]."

"This might support the Aussie market as there will be less supply going forward. For example, ANZ raised $1 billion in the US and we expect them to raise another $1 billion in Australia of the $2 billion they are refinancing later this year".

For Australian investors though, moat-rated hybrids should continue to find favour due to their higher yields, as part of a stable income investment strategy.